by Norma J. Williams, Esq.
Williams & Associates
Part 1: General Rules of Priority; Deeds of Trust
When two or more persons have liens on real property, priority rules establish which liens are superior and which are subordinate. Broadly speaking, liens may be established consensually, per the agreement of the parties (e.g. deeds of trust) or non-consensually and imposed by law (e.g. tax liens). In the case of consensual liens, the parties may agree to alter their relative priorities, primarily through the use of Subordination Agreements.
Part 1 of this article is an overview of the general California rules of priority, and some common priority disputes involving deeds of trust. Part 2 will discuss parties’ voluntary alteration of their priorities using Subordination Agreements. Part 3 will cover certain non-consensual liens including judgment liens and tax liens.
First in Time of Creation Is First in Right
California’s basic rule of priority governing consensual liens is in Civil Code Section 2897. That section states that other things being equal, different liens on the same property have priority according to their time of creation. Thus, a Deed of Trust dated and delivered by the trustor to the beneficiary in January, 2018 will have priority over one dated and delivered in February, 2018. This rule, however applies only if the second beneficiary had actual or constructive notice of the prior interest. Such notice can be actual, implied from circumstances, implied from possession, imputed (e.g. to an agent for a principal) or constructive. The primary method of establishing constructive knowledge is through the recording laws.
Effect of Recording Laws – Constructive Notice
The effect of California’s recording law can result in a later-created Deed of Trust having priority over one created earlier if four conditions apply: 1) the earlier Deed of Trust was not recorded; 2) the later beneficiary did not have notice of the earlier lien; 3) the later beneficiary gave value; and 4) the later Deed of Trust was recorded first. This is generally referred to as a “race-notice” system. California’s system differs from that in some other states that are pure “race” systems. Recent California law has held that where documents are recorded simultaneously but indexed sequentially, the priority of the documents can be determined from the parties’ intent. Lenders commonly rely on title company searches and title insurance to establish and protect the priority of deeds of trust vis-à-vis other interests.
Validity Between the Parties
The foregoing priority rules apply only to relative rights as between third party lien claimants. As between the parties to the document, the transaction is valid and enforceable if it complies with contract law for the creation of the interest. Thus, for example, an unrecorded Deed of Trust is valid to create a lien on real property as against the trustor, but the beneficiary may or may not have seniority over other lenders to whom the trustor also granted a security interest.
Some Common Priority Disputes Involving Deeds of Trusts
Modification of Senior Loans
It is not uncommon during the course of a financing for the parties to wish to change the terms of the loan. These changes may be as to interest rate, length of term, repayment schedule or otherwise. When a junior lien is placed on property, the lender agrees to lend based on the terms of the senior loan at the time that it makes the junior loan. Case law has held that a material modification of the senior loan that is detrimental to the junior lender and that is made without the junior’s consent may result in the modified portion of the senior loan or the full amount of the senior loan losing priority to the junior, depending on the facts. Prior to the effectiveness of the modification, diligence on the part of senior lenders contemplating modifications includes obtaining the consent of junior lender, consent of (or reaffirmations from) any guarantors (even if the Guarantys state that they are not affected by modifications) and obtaining appropriate modification endorsements to their lenders’ policy of title insurance.
Future Advances; Construction Loans
Future advances refer to amounts disbursed to the borrower after the initial loan is funded. A potential priority dispute exists when a junior lender records its Deed of Trust after the senior lender has recorded its Deed of Trust but before the senior lends additional funds to the trustor. Future advances arise often in connection with construction loans where loan proceeds are disbursed at various intervals during construction. They also arise in connection with revolving loans. In order for future advances to be secured by a Deed of Trust, the Deed of Trust must specifically state that it secures future advances.
The law in this situation distinguishes between obligatory advances and optional advances. Advances that a beneficiary is obligated to make by the terms of the loan documents are obligatory and have priority from the date of recording the Deed of Trust provided that the advance is made in accordance with the terms of the loan documents. The rule applies whether or not the senior lender has knowledge of the junior Deed of Trust.
Advances within the discretion of the lender are “optional” and are secured by the senior Deed of Trust. However, the priority of the amount of the advance vis-à-vis the junior loans, depends on whether the senior lender has actual knowledge of the junior lien. If the senior beneficiary had actual knowledge that the junior loan had recorded prior to making the advance, the senior lien has priority only as to its original amount. Knowledge imparted by a recording of the junior lien is not actual (but rather constructive). If the lender did not have actual knowledge, the additional advance has the same priority as the original amount of the senior lien.
Action to be taken by junior lenders before lending should include investigating the existence, amount and terms of the senior loan, giving notice to the senior lender and obtaining a beneficiary statement from the senior. The senior lender may seek title endorsements ensuring the priority of the advances, whether obligatory or optional, but as to the latter, exception will exist as to liens, encumbrances, or other matters after the date of the lender’s policy that are known to the insured before the date of such advances. Standard forms of title insurance also exclude matters that are known to the insured but unknown to the title insurer and not shown by the public records.
A mechanics lien entitles contractors, subcontractors, material suppliers and other persons that provide labor or materials on real property to claim a lien on the work of improvements and on the real property on which the work is situated. The California Mechanics Lien Law is contained in Civil Code Sections 8000-9566.
The concern of construction lenders is that a mechanics lien may have priority over the lien of its Deed of Trust. Mechanics liens take their priority from the date of the commencement of the work and have priority over any Deed of Trust that is later recorded. In California, the priority of all lien claimants relates back to the date when works commenced even if a particular claimant does not commence work or record its own lien until after the Deed of Trust is recorded. The most common protection against loss of priority is through title insurance. Title insurers will undertake physical inspections of the property prior to the disbursement of the loan to be sure that no work has commenced, a highly fact and contract-specific investigation. If a title insurance company would insure notwithstanding the commencement of the work, it would mostly require a secured indemnity and/or other financial accommodations to mitigate its risk.
In addition to requiring priority at the time of recording, construction lenders also require priority as disbursements are made to fund construction. The priority of such later advances vis-à-vis mechanics liens is also generally based on whether such advances obligatory or optional. However, a special rule exists for optional advances in the construction context. In that case, CA Civil Code Section 8456 provides that if a Deed of Trust has priority over mechanics lien (because no work had been started prior to its recordation), optional advances by the lender that are used for construction costs have the same priority as obligatory advances provided the total of all advances does not exceed the amount of the original loan. Optional advances used for other purposes do not have this priority. As a practical matter, it is customary for construction lenders to condition the release of each construction loan advance on obtaining unconditional lien releases and waivers from all contractors, subcontractors and other mechanics whose work is to be paid from the advance.
Purchaser’s Title at Foreclosure Sale
A purchaser at a foreclosure sale derives its priority from that of the Deed of Trust that was foreclosed. Thus, the purchaser acquires its title subject to liens that were on the property when the Deed of Trust was recorded but free of liens recorded thereafter. The junior interest is considered to be “sold out.” Although it is sold out, the junior lender has a right to surplus proceeds from the senior’s sale in the order of its priority and has the right to bring an action against the trustor on its note to recover the unpaid amount of the junior debt.
An exception to the above priority rule exists when the foreclosure is judicial and the junior lienor or interest holder was not named as a party in the Complaint. The title of the purchaser is subject to the junior lien, but the foreclosing lender retains its senior status and can foreclose on the unnamed junior interest.
The general rule that a non-judicial foreclosure purchaser derives its priority from the Deed of Trust being foreclosed is true whether or not the purchaser has knowledge of an interest that was recorded after the Deed of Trust but before the sale. Thus, when property is conveyed by a Deed that was not recorded until after the Deed of Trust recorded and the beneficiary later forecloses, the purchaser at the sale receives title free and clear of the interest of the grantee on the Deed. However, defects in a beneficiary’s title that existed at the time that a Deed of Trust was recorded (e.g. the beneficiary had prior actual knowledge of an unrecorded interest and thus was not a bona fide encumbrancer), the title obtained by the foreclosure sale purchaser would also be subject to that defect. However, if the foreclosure purchaser did not have knowledge of the unrecorded interest, then the race-notice system would cause it to have priority once it records its Trustee’s Deed.
Other Priority Disputes Involving Deeds of Trust
The foregoing are only some of the priority disputes that affect Deeds of Trust. Some of the others include those between a) a party refinancing a senior lien versus junior lienholders in place at the time of refinancing; b) a seller or third-party lender with a purchase money lien on real property as against certain pre-existing liens affecting the borrower personally; and c) tenants and lenders to their landlords.